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HMRC internal manual

International Manual

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HM Revenue & Customs
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Controlled Foreign Companies: EEA states - deduction for net economic value against apportionment: Examples of “Net economic value” created directly by work in an EEA state

NOTE: All these examples assume that the controlled foreign company is not eligible for

any of the exemptions available in the controlled foreign companies’ rules (though, as described, some would be).

Example 1a: Locating work in another EEA state - Operations

A UK parent company decides to set up a controlled foreign company in another EEA state to operate a call centre providing a helpline for the group’s European customers. The controlled foreign company opens an office in the other EEA state, appoints a management team there, installs the necessary call centre equipment and recruits local staff to man the help-lines.

The service to customers is part of the group’s real business. The work directly creates value for the group by contributing to the delivery of its business.

The UK company has already decided that an appropriate way to establish the “net economic value” of the work is to apply a “cost plus” method to estimate an appropriate profit for this work.

The local tax rate applicable to the profit for the work does not affect whether an application can be made under ICTA88/S751A. So, even if the cost of undertaking the work in the other EEA state is the same as it would have been in the UK, and the only reason that the work has been located abroad is because the local tax rate on the profit for the work is lower than the UK tax rate, an application can still be made.

Provided that the chargeable profits simply reflect the arm’s length provision for the work undertaken by the controlled foreign company and take account of the full economic costs of undertaking the work, then, in principle, an application covering the whole of the chargeable profits of the controlled foreign company might be granted.

Example 1b: Locating work in another EEA state: Intra-Group Services

A UK parent company decides to set up a controlled foreign company in another EEA state and to relocate, say, group payroll administration work there. The controlled foreign company opens an office in the other EEA state, appoints a management team there, installs the necessary IT equipment, and recruits local staff to undertake the payroll administration work.

The payroll administration service is an essential part of the group’s real business. The work directly creates value for the group by enabling the group to employ staff to deliver its business.

As in Example 1a, the UK company applies a “cost plus” method to estimate an appropriate profit for this work, for the purposes of establishing the “net economic value” of the work. Again, providing the chargeable profits of the controlled foreign company are in line with this, then an application covering the whole of those profits could be granted - even if the cost of undertaking the work in the other EEA state is the same as it would have been in the UK, and the only reason that the work has been located abroad is because the local tax rate on the profit for the work is lower than the UK tax rate.

Example 2: Diverting profits to a controlled foreign company using intra-group loans

A UK parent company decides to set up a controlled foreign company in another EEA state in order to route though it funds raised centrally through borrowings made in the UK to other group members. The funds are passed to the controlled foreign company by the UK parent in the form of equity. The controlled foreign company then passes them on to other group members, on the directions of the UK parent, in the form of interest-bearing loans. The controlled foreign company rents an office and pays two employees of a group company in the same Member State to carry out the necessary administration.

In this scenario, the income from the loans is not net economic value to the group as a whole. The loans simply transfer value from one part of the group to another. Even if there were any value, it would be attributable solely to the location of capital in the controlled foreign company and not to any work done by staff of the controlled foreign company.

No application under these rules is likely to be granted.

Example 3a: Diverting profits to a controlled foreign company by locating intellectual property in the controlled foreign company

A UK parent company decides to set up a controlled foreign company in another EEA state and place intellectual property in the controlled foreign company so that royalties are received there.

The controlled foreign company opens an office in the other EEA state appoints a small team of staff to undertake work involved in administering the intellectual property in the controlled foreign company and receiving the royalties.

In this scenario, little of the controlled foreign company’s income can be considered to constitute net economic value created directly by the individuals working for the controlled foreign company in the other EEA state. This is because the real economic value arises not from the administrative work carried out by the controlled foreign company’s staff but from the legal ownership of the intellectual property by the controlled foreign company.

In this case an application is only likely to be granted if the specified amount reflected just that part of the chargeable profits that reflected an arm’s length net return for the administrative work undertaken in the controlled foreign company.

Example 3b: Diverting profits to a controlled foreign company by routing ownership of group companies through the controlled foreign company

A UK parent company decides to set up a controlled foreign company in another EEA state and place shares in group companies in the controlled foreign company, so that profits distributed by those subsidiaries as dividends are received by the controlled foreign company.

Similarly to Example 3, generally this dividend income arises from legal ownership of the shares in the group companies, and is not net economic value created directly by the work of individuals working for the controlled foreign company in the other EEA state.

Example 4: Mixed activities

Instead of setting up a new controlled foreign company in another EEA state in order to route though it funds raised centrally through borrowings made in the UK to other group members, as in Example 2, the UK parent company decides to do this using the controlled foreign company that is operating the European call centre as described in Example 1.

As in Example 1, the appropriate way to establish the net economic value for the work of the call-centre is to establish the profit a third party would be likely to earn for the work. For example, it may be appropriate to use a ‘cost plus’ method to come up with an appropriate profit for the work.

As in Example 2 however, the income from the loans is not net economic value to the group as a whole, as the loans simple transfer value from one part of the group to another.

An application under the rules would only be granted if the amount specified in the application was limited to the appropriate profit for the work undertaken in the call centre, as in Example

Example 5: Treasury operations

A UK parent company decides to set up a controlled foreign company to undertake group treasury operations in another Member State so benefiting from a low rate of tax.

The controlled foreign company has an office in the other state with sufficient competent workers with the authority to borrow on the markets, manage the group’s exchange risks and on-lend the borrowed funds to group members; and they do all the work themselves in the other Member State.

The net economic value to the group that is created directly by the work in the controlled foreign company arises out of the treasury management and administration that, for example, enable the group to achieve economies of scale by borrowing on better terms than individual group companies could achieve. On third party terms, this might be rewarded with a small turn (say 25 basis points) on the interest rate to reflect the value of the work to the group and UK parent. An application can be made under the new rules, to the extent that the controlled foreign company’s profits comprise or include such an amount.

An application under the rules is likely to be granted if the amount is specified on this basis.

Example 6: Captive insurance, established in two other EEA states

A UK parent decides to set up a captive insurance controlled foreign company in another EEA state. The controlled foreign company has two agency staff in a business establishment in its territory of residence to handle administration and one employee to handle claims based in a rented office in another, different, EEA state. The UK parent has arranged for the investment activity to be outsourced from the controlled foreign company to third parties.

The administration and claims activity would be rewarded at arm’s length equivalent to, say, cost plus a modest mark-up in line with the provision of such services on third party terms. Such a reward would constitute the net economic value of the activity for these purposes. None of the profits from the investment activity will represent net economic value to the group from the work of the controlled foreign company, as it is not carried out by the staff of the controlled foreign company.

An application under the rules would only be granted if it is limited to the controlled foreign company’s profits representing the net economic value of the administration and claims work that the controlled foreign company’s staff do in the controlled foreign company’s two business establishments in other EEA states.

Example 7: Essential capital

A UK parent sets up a controlled foreign company in another EEA state to provide banking services. The controlled foreign company opens premises in the other EEA state, appoints a management team there, installs the necessary IT equipment, and recruits local staff to provide the banking services from the premises.

The local banking regulator specifies Tier 1 capital requirements for the controlled foreign company that are consistent with international norms on the essential capital required to undertake the relevant banking activity, but the UK parent chooses to keep three times as much capital in the controlled foreign company as equity.

An application can be made and granted under these rules if it is limited to the profits representing the net economic value arising from the banking activity undertaken in the EEA establishment by the controlled foreign company’s staff working there - after taking account of the economic costs of undertaking the activity, including the economic cost of financing the activity, over and above the essential equity capital.

To the extent that the extra capital has been used to finance the banking activity, with the result that the profits of the activity are higher than would otherwise have been the case, a deduction would need to be made for the purposes of establishing the amount of those profits that could be included in an application under the new rules. For example, by reference to how much it would have cost the controlled foreign company to have borrowed the extra capital.

(If any of the controlled foreign company’s capital is not used to finance the banking activity undertaken in the controlled foreign company’s EEA establishment but is instead invested with a third party, then the controlled foreign company’s investment income cannot be included in an application under these rules, as it does not represent net economic value created directly by the work of individuals working for the controlled foreign company in the other EEA state.)

Example 8: Sales/Supply chain

A UK group trading in the UK sets up a controlled foreign company in another EEA state to hold ownership of traded goods, issue invoices for UK sales and receive UK sales income. The controlled foreign company opens premises in the other EEA state, appoints a management team there, installs the necessary IT equipment, and recruits local staff to administer the issue of invoices and receipt of income. The managers in the UK group HQ undertake work to set up an intra-group contract for a UK member of the group to undertake work chasing and collecting overdue trade debts on behalf of the controlled foreign company.

The issue of invoices and receipt of payments is an essential element of the group’s trading activity, but the net economic value created by the work of individuals working for the controlled foreign company in the other EEA state is limited to the appropriate profit for undertaking this administrative work. Typically, this could be estimated by using a cost plus method. An application could be made under the rules if it is limited to controlled foreign company profits representing this amount.

Any extra profit arising in the controlled foreign company cannot be included in such an application - for example, if the group has located in the controlled foreign company the “buy/sell” margin created by the trading activity undertaken in the UK in the controlled foreign company. (Also, the net economic value to the group of the work undertaken to chase and collect overdue trade debts is created by the UK group member contracted to do this work.)